A model of a currency union with endogenous money and saving - - PowerPoint PPT Presentation

A model of a currency union with endogenous money and saving investment imbalances

• Dr. Dirk Ehnts

Guest lecturer Berlin School of Economics and Law dirk@hwrberlin.de YSI Berlin Workshop on the Financial Crisis

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Outline of this talk

• 1. Introduction
• 2. IS/LM and IS/PC/MR models
• 3. IS/MY model

a.Endogenous money (MY) b.The real economy c.Savings-investment imbalances (IS)

• 4. Economic policy
• 5. Conclusion

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Some general facts (I)

http://krugman.blogs.nytimes.com/2012/09/25/more-coulda-been-worse-blogging/

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Some general facts (II)

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Some general facts (III) Why is this crisis so difficult? Assets of some (Germany etc.) are liabilities of others (Greeks, Spaniards, Irish, etc.). Economics = politics !

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Problem: to explain the EMU crisis, existing models do not allow to show the whole „story“ and do not lead to the main issues. The European Commission (2009, 26) has recognized that: „a large part of the divergence in the current account in the euro area since the late 1990s can be traced back to domestic demand. There have been considerable and persistent differences in domestic demand across Member States since the launch of the euro.“

• 1. Introduction

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“differences in domestic demand across Member States since the launch of the euro.“

• 1. Introduction

„But where we differ is that I believe that within a monetary union the large capital inflows associated with optimism (or neglect of dangers) moving to particular countries or regions can still create expansions of demand there that lead to large changes in relative prices between traded and non-traded goods.“

Sleepwalking with Heiner by Robert Johnson on August 04, 2012

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“differences in domestic demand across Member States since the launch of the euro.“

• 1. Introduction

Source: http://www.bruegel.org/nc/blog/detail/article/895-spain-a-tale-of-two-crises/

Figure 1 – Cumulative capital inflows (% 2007 GDP)

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“differences in domestic demand across Member States since the launch of the euro.“

• 1. Introduction

Source: http://www.bruegel.org/nc/blog/detail/article/895-spain-a-tale-of-two-crises/

Figure 3 – Domestic Credit to GDP Italy Spain Portugal Ireland Greece

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• 1. Introduction

„In a tripartite agreement in 1999 government and negotiating partners on the labour market agreed not to allow growth of nominal wages along the lines of productivity growth and the inflation target of two percent (hitherto the traditional German approach) for the future but to remain clearly below that line. […] This implied that German ULC growth and its inflation rate would systematically remain below the commonly agreed inflation target in EMU.“

The Heart of the Euro Problem: A Response to INET's Rob Johnson by Heiner Flassbeck on August 08, 2012

“differences in domestic demand across Member States since the launch of the euro.“

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• 1. Introduction

“differences in domestic demand across Member States since the launch of the euro.“

http://www.ecb.int/press/key/date/2011/html/sp110610.pdf?8eb18c8563978097e257020cc1674791

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• 1. Introduction

“differences in domestic demand across Member States since the launch of the euro.“

http://www.disequilibrium.org/2011/12/germanys-fiscal-folly/

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• 1. Introduction

“differences in domestic demand across Member States since the launch of the euro.“

http://www.zerohedge.com/news/goldmans-take-target2-and-how-bundesbank-will-suffer-massive-losses-if-eurozone-fails

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• 1. Introduction

“differences in domestic demand across Member States since the launch of the euro.“

http://www.ecb.int/press/key/date/2011/html/sp110610.pdf?8eb18c8563978097e257020cc1674791

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Problem (2): Savings-investment imbalances, which are the financial side of current account imbalances, are not part of textbook models. We know from the balance of payments the following ex- post identity: (Sp – I) + (T – G) = (EX – IM)

Private sector Public Sector External Sector

• 1. Introduction

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Problem (2): Y = C + I + G + CA (1) CA = X – M (2) CA = Y – ( C + I + G ) (3) S = Y – C – G (4) S = I + CA (5) Sp = Y – C – T (6) Sg = T – G (7) (Sp – I ) + ( T – G) = (EX – IM) (8)

• 1. Introduction

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Problem (2): Given a more or less balanced budget – (T-G) = 0 – any increase in imports over exports must be financed by an increase in private sector debt. minus + zero = minus (Sp – I) + (T – G) = (EX – IM)

Private sector Public Sector External Sector

• 1. Introduction

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Problem (2): If any increase in imports over exports must be financed by an increase in private sector debt, then the next question is: How does that actually work? Textbooks tell us that money buys things and that the money supply is set by the central bank.

• 1. Introduction

Money (credit) demand Money (credit) Interest rate Money (credit) supply

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Problem (2): If this is how things work, than deposits at banks will allow banks to create loans … … however, none other than Kydland and Prescott (1990) have written: „There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly.“

• 1. Introduction

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Problem (2): The financial press tells us that the ECB sets the interest rate

(actually, more than one),

not the money supply!

• 1. Introduction

Money (credit) demand Money (credit) Interest rate Main refinancing

• perations

0.75% 1.50% Marginal lending facility Deposit facility 0.0%

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Problem (3): If this is not how things work, than perhaps loans will create deposits? The other idea missing is the view of money as endogenous as clearly the ECB sets the interest rate, not the monetary

• aggregate. As Lavoie (1985, 67) states:

[L]oans make deposits. Banks do not wait for the appropriate amount of liquid resources to exist to provide new loans to the public (mainly firms).

• 1. Introduction

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If loans make deposits, than banks create money

• endogenously. They do not need cash to make new loans

but just enter some numbers on their keyboard to make the balance sheet longer. Reserves must be put at the ECB at 1% of total deposits. Also, more liquidity might be needed for clearing. Can these banks perhaps borrow from the ECB?

• 1. Introduction

Periphery Bank Loans +100 Deposits +100

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... sure they can!

• 1. Introduction

http://www.ecb.int/pub/pdf/scpwps/ecbwp359.pdf

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• 1. Introduction

Source: http://www.bruegel.org/nc/blog/detail/article/895-spain-a-tale-of-two-crises/

Figure 2 – Eurosystem Liquidity Italy Spain Portugal Ireland Greece

… sure they do!

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• 1. Introduction

Source: http://www.bruegel.org/nc/blog/detail/article/895-spain-a-tale-of-two-crises/

Figure 3 – Domestic Credit to GDP Italy Spain Portugal Ireland Greece

… and then the domestic lending was financed by endogenous money first and …

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• 1. Introduction

… and later the financial assets were bought either directly or indirectly by German banks and their subsidiaries (if they did not finance them in the first place). That would explain the losses and/or bankruptcies of German banks.

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• 1. Introduction

The Machinery of the mind can only transform knowledge, but never originate it, unless it be fed with facts of observations. Charles S. Pierce in How to Make Our Ideas Clear (1878) To think is to forget a difference, to generalize, to abstract. Jorge Luis Borges in Funes the Memorious (1942) Now that we know what is within our reach and what is not, let us come to the existing models!

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The IS-PC-MR model (Carlin/Soskice 2005, 5)

(Dynamic Stochastic General Equilibrium / New Neoclassical Sythesis)

Endogenous money? Inter-temporal optimization =no defaults! Saving-investment imbalances? S=I!

• 2. IS/LM and IS/PC/MR models

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The IS-LM(-BP) model Endogenous money? Central bank controls monetary aggregate (except liquidity trap) Saving-investment imbalances? I=S! interest rate income IS LM UIP

• 2. IS/LM and IS/PC/MR models

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The IS-MY model endogenous money (MY) + (income-expenditure) real economy + savings-investment imbalances (IS) Goal: Simple analytical tool to explain the monetary problems

• f an economy (in a currency union, in this case).

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endogenous money (MY) Topsy-turvy quantity equation: changes in AD drive Y, which then drives M (given P and V)!

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(income-expenditure) real economy Aggregate demand drives income, in a simple standard income-expenditure model. Note that the current account is part of aggregate demand.

assumption: G – T = 0 assumption: EX – IM = 0

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savings-investment imbalances (IS) A rise in aggregate demand leads to savings<investment since imports increase. The position of the Sp-I curve depends on (G-T). (Sp – I) + (T – G) = (EX – IM)

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Expectations in the real economy (I) determine the amount of loans (II) demanded by the private sector to finance parts of aggregate demand (III). Net savings (IV) are the result of behavior in the economy.

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Expectations in the real economy (I) drive the amount of loans up (II) as more aggregate demand is financed by debt (III). Net savings (IV) are falling as a result of the rise in imports and decline of the current account.

Friedrich A. von Hayek

Achtung: Over-

investment!

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Expectations in the financial part of the economy drive savings up (I) and aggregate demand – incl. investment – down (II). Income falls (III) and (foreign) loans are repaid (IV).

Balance sheet recession!

Richard Koo

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Government spending increases aggregate demand (I) and therefore income (II). High-powered money increases. Private net savings rise (III). No change in trade (IV).

Stabilizing an unstable economy!

Hyman Minsky

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European Monetary Union (EMU) A critical look at the first years Without any tools to directly influence the level of aggregate demand – monetary, fiscal and exchange rate – the countries could follow three paths to bring up aggregate demand: 1) Private sector lending increases 2) Public sector lending increases 3) External demand increases Different countries went along different paths, as we know.

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Viva la Vivienda!

Domestically financed real estate bubbles drove the real economy as more and more households went into debt to buy houses with prices ever-increasing: Spain, Ireland

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Spain 1999-2007: Investment > Saving, G=T, net imports

€

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Ireland 1999-2007: Saving > Investment, G=T, net exports Nota bene: Irish household debt increased, so if the private sector net saves it must be the firms, right?

€

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While GNP measures the output generated by a country's enterprises (whether physically located domestically or abroad) GDP measures the total output produced within a country's borders - whether produced by that country's

• wn local firms or by foreign firms.

http://notesonthefront.typepad.com/politicaleconomy/2012/07/the-good-the-bad-and-the-curious.html

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Export- Weltmeister

(long run)

Relative prices are deflated by letting wages grow slower than productivity (I). Loan demand is weak, whereas exports increase because either …

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Export- Weltmeister

(long run)

…they are very competitive (III) and the trade partners finance them by moving into debt (IV) OR capital flows out

• f the country (IV) and finances imports elsewhere (III).

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However that is, weak growth rates resulted in the German economy from 2002-2005. Demand was propped up by an increase in government spending during these times.

2002 2005

4% 2% 0%

• 2%
• 4%
• 6%

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Germany (2002-2005): Saving > Investment, G>T, net exports, then (2006-today): Saving > Investment, G=T, net exports

€

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Complications If one country has private sector net savings and is a net exporter, some other country is forced into a position of a net importer with either public or private sector (or both) moving into debt. Or vice versa, which however is unlikely. Some strategies are ruled out, like all countries increasing (net) exports and no countries increasing imports! Last but not least, let us have a look at how austerity (T>G) will affect the EMU economies according to the model…

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Government spending falls, (relative) prices fall, imports decline as GDP shrinks and exports increase. However, the private sector now cannot decrease debt: Sp=I!

Rebalancing, scenario I: weak export demand

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If only exports would increase faster, than the situation would allow the private sector to repair its balance sheet and would lead to Sp>I, which is badly needed.

Rebalancing, scenario II: strong export demand

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Conclusion: The IS/MY model … … can be driven by the financial or real side … is driven by aggregate demand in part financed by … endogenous money (and exogenous money) … shows how deficit spending works … highlights the importance of debt (stocks) … can explain a capital account-driven economy and a current account-driven economy … shows interconnected economies and their strategies … can account for exogenous changes in price level

* not shown in the slides but in the paper.

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Conclusion: The IS/MY model … …is all you need to explain many different ideas about what caused the financial crisis and its balance sheet character allows you to rigidly examine policy ideas given a certain

• environment. Economies must be understood in the context
• f their neighbors, with which they are interdependent!

The model predicts that austerity in times of general lack of demand will fail, while in good times it might work. Each financial crisis is different, and not all policies work all of the time.

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Thank you for your attention.